1. Field of the Invention
This invention relates generally to trading strategies in securities markets. Particularly, this invention relates to a method and system for automatically determining an immediately executable trade list, or “wedge,” which both satisfies user constraints, and advances the objectives of the traders, such as minimizing the overall risk to a portfolio of financial security holdings.
2. Background of the Related Art
Various automated trading systems are known, which execute so-called “program” trading strategies in response to market movements.
Generally, portfolio managers for large institutional investors, such as mutual funds, hedge funds, etc., are responsible for trading large blocks of financial securities. These portfolio managers typically prefer not to send large market orders, which may have adverse market implications creating inferior execution prices. However, a portfolio manager's desire to avoid negative trade implications must be balanced with the time frame within which the portfolio manager's trades must be completed. In order to best satisfy the competing criteria, portfolio managers, generally, divide large trade blocks of financial securities into multiple smaller portions which are sent over the given time frame according to a predefined trading strategy. Generally, such a predefined trading strategy would minimize risk to the unexecuted portion of the larger trade block by minimizing unfavorable market movements caused by the execution of the smaller orders.
An example of a known trading strategy is the treatment of an unexecuted trade list as a long-short portfolio and utilizes a multi-factor risk model to construct a minimal risk “portfolio” of unfilled orders to be sent simultaneously for execution. The minimal risk “portfolio” when executed minimizes the risk to short-term return of the unexecuted trade list.
The Markowitz Model (as described in “Portfolio Selection,” Dr. H. M. Markowitz, Journal of Finance, Mar. 7, 1952), is a well-known optimization strategy that balances the expected return and risk of a portfolio to allow the construction of one such minimal risk “portfolio.” The decision variables used in the model are the amounts invested in each asset. According to this model, the statistical variance of a stock's price is used as a measure of its risk, the expected return of the stock is used as a measure of its utility or long-term prospects, and the variance of a portfolio's return is derived from the covariances for the returns of the individual assets in the portfolio.
Variance is a measure of fluctuation in the rate of return of an asset, such as a financial security. Generally, higher variance levels indicate higher risk investments. Covariance is a measure of the correlation between return fluctuations of multiple assets. A high covariance between two assets indicates that an increase or decrease in one asset's return is likely to correspond to a parallel increase or decrease in the second asset's return. Conversely, a negative covariance indicates that an increase or decrease in one asset's return is likely to correspond to an opposite increase or decrease in the second asset's return. Moreover, a low covariance indicates that the return rates of the two assets are relatively independent, meaning an increase or decrease in one asset's return will have little or no effect on the return of another asset. Thus, the risk of a portfolio is best determined not by a simple weighted average of the risks of individual assets in the portfolio, but instead by assessing the relationships between the returns of the various individual assets in a portfolio.
A shortcoming of the known trading risk objective model is that it fails to account for short-term effects that each trade has on the overall portfolio of holdings, which includes securities not to be traded and unexecuted securities to be traded. Further, this shortcoming is exacerbated when portfolio managers must adhere to certain constraints in their trades, thus limiting the viable options for any given trade.
Thus, there exists a need for improvements in the art which allows for proper selection of the best trade option from all viable trade options which a portfolio manager has available. This selection should be based on both the objectives of and constraints on the individual trades.